At the original Bretton Woods conference in 1947, one of Keynes' proposals for the new financial architecture was for an adjustment mechanism that would penalise persistent creditor nations. Keynes was acutely aware of the problem that emerges when one set of countries run huge surpluses. This is the problem of adjustment - at turning points in the cycle, adjustment is always mandatory for debtor nations but optional for creditor nations. It is this basic fact that renders any free international financial system inherently political. When the debtor nations are small and lacking systemic influence, they typically find themselves at the mercy of the big boys (e.g. Asian financial crisis, Mexico 1994, Latin America 1982 etc.). When the debtor nation is large and systemically indispensible (i.e. the US now), adjustment can be delayed for a long time. But it must occur eventually, and given recent newsflow and datapoints it would seem a good bet that this adjustment will now happen over the next 1-2 years.
So what? Why does this matter for emerging markets? It seems almost certain now that the US is going start saving considerably more. Over the past cycle the excess savings stemmed from emerging markets, which were in turn lent out to the US to finance the leveraged boom. Emerging markets were essentially following an export-led growth model: keep exchange rates down, prioritise investment over consumption, promote exports. This is fine so long as there is demand for your exports. Unfortunately in the new world of a thrifty US consumer, there is going to be no marginal buyer for these exports. Therefore, if emerging markets try to adopt the same export led growth strategy as they have over the past cycle, we risk drifitng into a low-level equilibrium. We would have a global paradoox of thrift - increasing savings in both the US and emerging markets, but lower overall demand for goods. Clearly this would be a disaster.
History has shown that the best way out of these situations is for the creditor nation to embark on domestic fiscal expansion in order to stimulate domestic demand - see Martin Wolf's recent article on this point. I am increasingly coming round to the view that this could be the single most important macroeconomic challenge over the next cycle. If emerging market policy makers can get it right, then we could revert to the 3-4% global economic growth rates of the past. But if they try to follow the policies of the past cycle then I fear we could be in for a seriously pro-longed slump. The world has changed, and policy needs to change with it. In this regard, China's stimulus package is very encouraging, but there will need to be a lot more where that came from.
Wednesday, November 12, 2008
Tuesday, November 11, 2008
Investment versus consumption
I am becoming rather worried about investment spending. Yesterday, one of my colleagues returned from a meeting with his investment trust board in which the finance director of a UK utility and a board member of a major bank told him that credit is essentially not being advanced to anyone, regardless of their perceived creditworthiness. The finance director said that companies were now basically being run for cash, which is then being hoarded to protect against any refinancing risk.
If this is true - and to be fair I have heard conflicting reports from other sources suggesting that credit is still available to some companies - then it does not bode well for any kind of discretionary corporate spending, whether it be expansionary capex, advertising and marketing or R&D. As is well known, investment spending is the most volatile component of GDP. Just take a look a the following chart, which shows investment spending in the UK economy over the past 50 years.
If this is true - and to be fair I have heard conflicting reports from other sources suggesting that credit is still available to some companies - then it does not bode well for any kind of discretionary corporate spending, whether it be expansionary capex, advertising and marketing or R&D. As is well known, investment spending is the most volatile component of GDP. Just take a look a the following chart, which shows investment spending in the UK economy over the past 50 years.
Admittedly the last two quarters of data (Q1 and Q2 2008) were negative, but only marginally so. We are a long, long way away from the -10% to -20% seen in past recessions. With the credit market still bunged up and managements terrified of a recession, it seems pretty unlikely that we wont see at least a few quarters of -10%. Of course with the recent sell off in everything exposed to corporate end markets it may be that the shares are already pricing in this outcome, even though consensus estimates clearly are not. However against this stocks do still seem to go down on the profit warnings, as Cookson showed today.
The other thing to remember is that, for all the bearishness on the consumer, consumption expenditure is much less volatile than investment. Over the past 50 years, the reported number has never been worse than -4% y-oy. Of course within this there will be a large variation - electrical goods will be a lot worse than clothing, which will be a lot worse than food etc. Nevertheless, I can't help but feel a little more positive on the consumer, at least on a relative basis - big downgrades have already been put through, interest rates are coming down etc., - while none of this has really begun yet for the industials.
Sunday, November 2, 2008
Bretton Woods 2 - the end of an era?
With the worst of the current financial crisis apparently past, now is perhaps a good time to reflect on what was and what was not correctly anticipated beforehand. For my own part, there is no escaping the fact that my record has been pretty mixed. Looking back over some of the past posts on this blog and recalling my own views at the time, it seems that I was very much correct in my skepticism of the "de-coupling" thesis, and particularly of those investors who were bearish on equities generally but bullish on China, India, mining etc. However, the events of the past couple of months have shown my bullish (relative to consensus) views on equities to have been spectacularly wrong. So the natural question to ask is how did I manage to get half so right and half so wrong? (Or was it just luck!?).
First off, it is important to recognise that crises are always so much clearer with hindsight. What started with some property related write-downs at US banks had escalated, despite numerous policy interventions, into a global banking crisis, and now what looks like a recession in the real economy too. The following diagram shows my understanding of how the financial system worked prior to the beginning of the crisis in summer 2007.
This is not particularly ground-breaking - indeed, many observers no doubt had a similar view of how the system operated. What is interesting however, is that fact that many commentators (although by no means all) expected the crisis to emanate from the emerging markets, rather than directly inside the western financial system. There was much analysis of the build up of Chinese reserves, whether this was a good thing or a bad thing, what would happen to the dollar and interest rates if they started diversifying etc. etc. When the crisis did hit, I think many people (especially equity investors) failed initially to understand its significance because they were looking for it elsewhere.
For my own part I was certainly guilty of this. When you look at the above diagram, it is so blindingly obvious that the breakdown of the process of credit creation should put a serious spanner in the works. It is not hard to see that a de-levering puts the whole cycle of flows into reverse (switch all the arrows round and then think about the consequences!). I had correctly understood that de-coupling was a myth, but I had not correctly anticipated the extent to which the de-levering itself would drive down all equity prices. I simply looked at valuations and said - "well, clearly mining and commodities are overvalued, but the rest of the market is pricing in a recession anyway and therefore doesn't look too expensive".
But my valuation argument has been shown to be largely irrelevant as many company valuations have gone careering through trough multiples anyway. Stocks that I thought could not go any lower have indeed continued to go lower. In fact, the cheapness of equity markets really depends on your time-frame. My valuation assumptions had been based on data for the past 15 or so years. What I should have realised was that the scale of the structural changes under way presented a serious risk to these assumptions. On longer-term valuation metrics, equities did not look quite as cheap. After the recent falls they do now look cheap, although (somewhat worryingly) they have in the pas fallen even lower.
First off, it is important to recognise that crises are always so much clearer with hindsight. What started with some property related write-downs at US banks had escalated, despite numerous policy interventions, into a global banking crisis, and now what looks like a recession in the real economy too. The following diagram shows my understanding of how the financial system worked prior to the beginning of the crisis in summer 2007.
This is not particularly ground-breaking - indeed, many observers no doubt had a similar view of how the system operated. What is interesting however, is that fact that many commentators (although by no means all) expected the crisis to emanate from the emerging markets, rather than directly inside the western financial system. There was much analysis of the build up of Chinese reserves, whether this was a good thing or a bad thing, what would happen to the dollar and interest rates if they started diversifying etc. etc. When the crisis did hit, I think many people (especially equity investors) failed initially to understand its significance because they were looking for it elsewhere.
For my own part I was certainly guilty of this. When you look at the above diagram, it is so blindingly obvious that the breakdown of the process of credit creation should put a serious spanner in the works. It is not hard to see that a de-levering puts the whole cycle of flows into reverse (switch all the arrows round and then think about the consequences!). I had correctly understood that de-coupling was a myth, but I had not correctly anticipated the extent to which the de-levering itself would drive down all equity prices. I simply looked at valuations and said - "well, clearly mining and commodities are overvalued, but the rest of the market is pricing in a recession anyway and therefore doesn't look too expensive".
But my valuation argument has been shown to be largely irrelevant as many company valuations have gone careering through trough multiples anyway. Stocks that I thought could not go any lower have indeed continued to go lower. In fact, the cheapness of equity markets really depends on your time-frame. My valuation assumptions had been based on data for the past 15 or so years. What I should have realised was that the scale of the structural changes under way presented a serious risk to these assumptions. On longer-term valuation metrics, equities did not look quite as cheap. After the recent falls they do now look cheap, although (somewhat worryingly) they have in the pas fallen even lower.
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